Motley Fool Flogs One Pick for your IRA? Weekend Thoughts

I generally try to keep an eye on many of the major newsletter publishers, and one thing that has stood out in my mind is the nearly singleminded focus of one of them, James Early, on a single high dividend stock that has cratered.

I note this for you today because he’s out with yet another public recommendation on this stock, urging investors to buy up now with both 2007 and 2008 IRA contributions, with both fists.

The interesting thing is that this editor, who shares the responsibility for editing the Income Investor newsletter from the Motley Fool, is repeatedly pulling out this one investment, again and again, as the best stock available to buy right now.

The stock is CapitalSource (CSE), a company that I also own shares of (and that is located just down the road from me).

Why is this interesting? Well, we have an editor staking his reputation on a single stock (that’s what it feels like to me when several “special reports” single this out as his most appealing buy) at a time when that stock is cratering.

The first time I noticed Early recommending CSE was back at the end of the Summer, when he urged investors to buy up shares because it had been unfairly tarred by the subprime brush.

And the last time was just today, when I saw the recommendation that this, and this alone, was what you should use to supercharge your IRA contributions.

Now, I like the company, too, but I wouldn’t stake my reputation (what little reputation I might have, that is) on this one at the moment.

Here’s the good:

It’s extraordinarily appealing on the dividend front, a yield of 17% at today’s severely depressed price.

CapitalSource is focused on middle market loans, which is an underserved market that the big guys don’t go after. And midsize private businesses are going to need money no matter what happens to the economy. They also are focused on healthcare, which is certainly a growth area (financing healthcare companies, and mortgaging facilities, that kind of thing). Their CEO did very well for his last company, which was also in healthcare finance.

They also have been considered to be fairly conservative — most of their loans are backed by tangible property of some kind, and they aggressively pursue nonperforming loans.

And the bad:

They are a mortgage REIT. In today’s environment, that’s like saying you’re a sex offender — there isn’t a “good kind.”

The downturn of the last few days is related largely to the news about KKR and Thornburg — people are terrified of these REITs. CSE only owns residential mortgages to the extent that they’re required to hold them to remain a REIT, and they count on their non-mortgage business to drive their profitability, but they do hold a big portfolio of (mostly prime, Fannie Mae and the like) mortgage paper. Unfortunately, over the last couple days people are even turning away from FNMA bonds, so they may have to end up writing down some of those holdings — I have no idea what impact that could possibly have on their balance sheet, but I suspect that’s where recent fear could come from.

They don’t make enough money in profits to cover their dividend, so much of it is return of capital right now. The company says that this environment is what their company was “made for” and that they should be able to make good, high profit loans with less competition in the marketplace. Management has been cagey about when they believe they’ll be able to cover the dividend with actual free cash flow or earnings, but they do certainly have plenty of cash to cover it for now.

One way that the company was hoping to lower its cost of funds was to get access to deposit funds by acquiring or starting a bank. They had a deal to buy TierOne, a small bank in Nebraska, but that appears to have fallen apart (though it may be renegotiated), or they might start an industrial bank of their own if they can get the right regulatory approvals. The nice thing about acquiring TierOne would have been that they could have access to low cost funds from depositors — the bad thing, of course, is that TierOne is a bank and, like all banks, has some level of terror associated with its own balance sheet.

On balance, I agree that CSE is being unfairly tarnished because it shares a space with some very unfortunate firms, but I also see a fair amount of risk ahead — just because I think the CEO will do the right thing and that they will be well suited to emerge from this crisis with a good book of business, doesn’t mean I’m right or that the market will agree with me.

So … I just thought I would call your attention to this one, since Early seems to be pushing it so hard even as it has fallen from over $20 to about $13 in the last six months. I currently own shares of CSE, but they are underwater right now. I also own protective puts against those shares that would offset any further losses if there is some catastrophic problem — my feeling from management and from their filings is that there won’t be, but God knows smarter people than I have been very, very wrong about many similar companies.

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Share your thoughts...

I have to tell you I don’t know what is wrong with my, listening to your call on this stock and buying puts, I don’t know why I have not protected my downside more in this market. Even on GE and Verizon would have been helpful.

Well, if you’re planning on holding through thick and thin and are really confident in the company, often puts are just a waste of money (though they can help you sleep better). I usually only put on “insurance” like this for my largest holdings.

Regarding JPD’s comment-I bought puts on my Verizon position, and it hasn’t helped much. I bought in the money puts twice, in January, and then again in February. The puts I purchased in January softened the blow because the market was so crazy in the third week of January, so there was enough momentum/volatility to move them. Can’t say the same for the puts I hold now. They are just decaying–and the stock moved just far enough out of the range it was trading in to further that decay faster–they are out of the money, now. So, Stockgumshoe is right–it… Read more »

FROM ALL OF THE PUNDITS,IT APPEARS BANKS ARE IN FOR A ROUGH RIDE.SO MANY CEOS EXCEPT MOZILA TRY TO PAINT A BETTER PICTURE. MY LONGER TERM GUESS WOULD BE WHEN THE FORECLOSURE RATE TAPERS OFF, AND SUPPLY OF THE BUILDERS EVAPORATES, THE LOW FED RATES WILL KICK IN TO STIMULATE THE REAL ESTATE MARKET AND BANKS WILL TAKE OFF IN THE TURNAROUND, BUT THIS IS A FUTURE PREDICTION AND INVESTORS WILL HAVE TO BE PATIENT AND ABSORB THE DOWNSIDE RISK TILL THE DOLLAR RECOVERS AND REAL ESTATE FINALLY CONSOLIDATES AND STARTS RECOVERING.

CSE is on my watch list with just two years of dividend payments behind them, I am not ready to commit any cash. I am watching what the dividend will do in the near-term. For the higher risk segment of my portfolio, I prefer ACAS.

I sold July puts @ 60-70% vol. I hope to be put, average cost will be $11.40.
1) they have about a 10% increase in shares through their DSPP. This is good short term cash but will increase their div payout.
2) banks are starting to cut funding lines. This is death for these businesses.
3) TierOne deal could very likley fail.
Look at MMAB – they cut their div by 50% and the stock tanked +60-70%.
At implied vols like these SELL puts if you want to own, don’t buy puts and be long stock.

It seems mortgage REITs may be approaching good buying opportunity if u have the stomach/nerve for it. I see that FBR has insiders buying heavily at these prices- over $3 million each direct share purchase for 2 insiders- Chairman & director I think.

I don’t usually remember to go back and mention my holdings on older posts, but thought I’d note that I did get stopped out of about 70% of my CSE holdings today when everything sunk on the Bear Stearns news. I’m still holding the protective puts, one of the few positive movers in my portfolio today.

I put my entire 2007 Roth IRA contribution into CSE in early April; it’s gone from $10.82 to $15.75 in less than two months. Pretty much just dumb luck, I think, but I’ll take it 🙂

As for why the Motley Fool report was specifying IRA: it’s an REIT, which means the actual dividend portion of its dividends (not the returned capital portion) is taxed at your top marginal rate. Sticking it in an IRA delays those taxes until you withdraw the money (unfortunately, it converts your capital gains to ordinary income at that point, too).

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